Canada: Montreal Exchange Seeks Regulatory Approval To Launch New Futures Contracts on Carbon Dioxide Equivalent (Co2e) Units

The Montréal Exchange ("ME") is seeking securities regulatory approval for the Montréal Climate Exchange ("MCeX") including amendments to several of its own rules¹ that would pave the way for a listing and trading of futures contracts on carbon dioxide equivalent units ("CO₂e Futures Contracts") on the MCeX². The CO₂e Futures Contracts would permit major industrial carbon dioxide emitters, financial institutions, insurance companies and other market participants to more efficiently deal with the expected introduction of a Canadian market for greenhouse gas ("GHG") emissions by the federal government in 2008. The new rules have been submitted to the Autorité des marchés financiers in Québec for approval on October 5th, 2007, with a thirty-day period for public comments. The CO₂e Futures Contracts will trade on the MCeX, which is the product of an alliance between the Montréal Exchange and the Chicago Climate Exchange®, a key player in the international carbon markets.

The Canadian government published a federal plan in April of 2007³ that will require selected industrial GHG emitters to reduce the relative amount of GHG they produce per unit of economic output ("intensity-based GHG emission reduction targets"). As part of this plan, the government will issue Regulated Emitters’ Credits at the end of a compliance year to regulated emitters that reach their industry-based GHG emissions reduction target and reduce the intensity of their GHG emissions below the target established by the federal government. Emitters can then bank the credits for future compliance years or can sell the credits. The federal proposals also provide for offset credits where companies that are not subject to intensity-based emissions reduction targets voluntarily generate credits to reduce their GHG emissions ("Offset Credits"). The CO₂e Futures Contracts will be based on these Canadian credits.

Several features of the federal proposals hamper the emergence of a strong Canadian carbon market. Instead of participating in the buying and selling of RECs and Offset Credits to meet their GHG reduction requirements, companies can also comply by contributing to a technology fund ($15 a tonne) or by purchasing international emission credits (CERs or Certified Emission Reductions) under the Kyoto Protocol’s Clean Development Mechanism.⁴ In addition, it is unlikely that offset credits will be available in the early years at least because of the regulatory uncertainty that still exists about the regime for the generation of those offset credits. Project participants will be hesitant to become involved in the creation of offset credits before this regulatory certainty exists. There is also uncertainty as to how the federal proposal will be integrated with provincial schemes such as the one in Alberta where emitters can meet 100% of their intensity targets through the contributions to a technology fund at $15 a tonne. Nevertheless, the MCeX expects that the federal government’s plan will create sufficient demand for the establishment of a carbon market in Canada in 2008.⁵

The MCeX is proposing two types of CO2e Futures Contracts, a futures contract with physical settlement and a futures contract with cash settlement. The underlying asset for both futures contracts is a Canadian carbon dioxide equivalent unit (CO₂e unit), as issued by the federal government and defined by government legislation. Each CO2e unit allows a holder to emit one metric ton of carbon dioxide equivalent (CO₂e). One futures contract will cover 100 such units.

The CO2e Futures Contract with physical settlement will have the following features:

• The holder will be entitled to physically obtain CO₂e units, which can be used to comply with regulatory requirements under the government’s GHG reduction plan.

• The transfer of CO₂e units will occur via the Canadian Derivatives Clearing Corporation (CDCC) and will also be monitored by a national registry set up as part of the government’s plan.
• The expiry of the contracts will match the compliance periods imposed by the Canadian regulatory framework (annually starting in 2010).

• Exchange for physical transactions, exchange for risk transactions, substitution of OTC (over-the-counter) derivative instruments for futures contracts transactions, block trades, pre-arranged transactions and cross transactions will be permitted.

• Where the delivery of a CO₂e unit cannot be arranged within the normal mandatory period, an alternative delivery procedure will be provided, which would allow a seller and buyer to consummate delivery under terms different from the specifications in the futures contracts.

• A position limit and a minimum position reporting threshold will be set up by the MCeX.

• The CDCC will establish the rules in case of a shortage of Canadian CO₂e units.
• The contracts will contain a force majeure clause in case the federal government abandons its plan to introduce a Canadian carbon market. Should this happen, the physical delivery of CO₂e units will be replaced with a special cash settlement determined by the Montréal Exchange.

• The CO₂e Futures Contract with cash settlement will have the following features:

• There will not be a physical delivery of CO₂e units. Rather, upon expiry, all open positions will be settled in cash.

• The final settlement price will be based on an index or survey of major industrial emitters reflecting the market price of a CO₂e unit.

• There will be coordinated expiry dates (daily, monthly, quarterly and annually) to allow for flexible investment strategies.

• Exchange for physical transactions, exchange for risk transactions, substitution of OTC derivative instruments for futures contracts transactions, block trades, pre-arranged transactions and cross transactions will be permitted.

• There will be a force majeure clause similar to the one in the futures contract with physical settlement.

The proposed operation of the MCeX will provide a valuable tool for industrial GHG emitters and other market participants to manage risks related to their GHG reduction obligations under the federal government’s proposals. While there is still some uncertainty regarding the details of the federal plans, and while some of the features of the plan may not be optimal for fostering a strong market, the creation of the MCeX represents an important step forward in the emergence of a Canadian carbon market.

© Copyright 2007 McMillan Binch Mendelsohn LLP